Europe to open higher but volatility continues to cast a shadow

14:00, 12 February 2018
· By Michael Hewson

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European markets look set to start the new week firmly on the front foot, a welcome respite after two weeks of sharp falls, helped by the strong rebound in US markets on Friday that saw the Dow and S&P500 both rebound off their weekly lows, with the S&P500 touching its 200 day moving average for the first time since June 2016.

Even though US markets enjoyed a positive day on Friday the late rebound can’t disguise the fact that US, as well as global equities, have undergone their worst fortnightly this decade.

For a market that has enjoyed steady gains and fairly low volatility over the course of the past two years the steepness of the falls speaks to a complacency that has been prevalent for a while now and which appears to have been shattered in the wake of a surge in volatility.

How this plays out over the coming days depends on whether the rebound we saw on Friday can translate into some form of base for a continuation of the uptrend that has been in place for the last nine years. This may well depend on whether we see further increases in bond yields, or a rise in interest rate expectations from other central banks around the world.

On the plus side US yields didn’t close much higher last week than they did the previous week, even if equity markets reacted as if they had. If yields do soften a little in the days ahead that could help aid a rebound in equity markets more broadly, however if we do see the US 10 year push up through 2.9% towards 3%, that could well prompt further weakness across the board.

There are other concerns, US margin debt still remains near record levels and the prospect of further losses, combined with the prospect of higher rates could prompt further jitters, not to mention the untried reaction function of a whole new breed of equity investors and traders who have never experienced the type of volatility that we’ve gone through over the last few days.

It is true that economic fundamentals remain fairly solid but it is also important to remember that this is already probably priced into US equities already, given that we’ve now seen tax reform get passed, along with a new US budget, which in itself is likely to see bond prices come under further pressure.

We’ve already seen a raft of US companies announce significant increases in salaries and bonuses and this was followed last week, with the news that German metal workers won a 4.3% wage rise, a trend that looks set to be replicated across the world, as governments urge employers to increase minimum salaries to more acceptable levels.

As wages start to rise, prices are likely to follow suit and with that interest rates, which is likely to hurt companies that have large amounts of debt, while the cost of servicing it will increase. This means investors will need to be more discerning about where they put their money as shareholders in Carillion and Capita to name but two will testify.

This uncertainty over inflation means that this week’s CPI inflation numbers from the UK, Germany and the US are likely to be closely scrutinised particularly in light of last week’s hawkish Bank of England inflation report.

While the pound slipped back after EU chief negotiator Michel Barnier’s rather unsubtle threats about a transition deal not being a given, the focus is likely to be on whether UK policymakers are thinking with one voice about the prospect of a possible May rate rise.

Later this morning we get to hear from two external Bank of England policymakers, Gertjan Vlieghe and Ian McCafferty on what their thoughts are on the UK economy and more particularly interest rate policy.

EURUSD – weekly evening star reversal suggests further downside while below the 1.2330 level, towards the 1.2160 area. We need to get back above 1.2330 to stabilise. Resistance remains back at the recent highs earlier this month just above the 1.2500 area.

GBPUSD – similarly weak weekly close has seen sterling push below 1.3830 last week raising the prospect of further losses towards the 1.3660 area. We need to get back through the 1.3970 area to stabilise and retarget the 1.4070 level.

EURGBP – continues to trade between trend line resistance just above the 0.8900 area and longer term support between 0.8700 and 0.8730. We have interim support at the 0.8800 area.

USDJPY – has struggled to push much beyond 109.80 at the end of last week, and last week’s low at 108.00 suggests we could slip lower towards the 107.20 area in the short term. Resistance remains up near the 110.2 area in the short term.

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